Co-Investors Posts

Summary: Angels make more introductions than VCs because angels need co-investors. You can’t clear the market in series–you can only clear it in parallel. Tranches are dumb–they have zero upside and catastrophic downside. Two investors aren’t always better than one. Finally, a ‘very special’ message to graduating Y Combinator founders: don’t do deals on D-Day and feel free ping us if you want additional help.

Adam Smith from Xobni, a Y Combinator company, calculates that angels made 5 times as many intros as VC investors while Xobni was raising a Series A:

“We spoke with 16 angels and 12 VCs. Angels made 24 introductions; VCs only made four. The average angel introduced us to 1.5 other investors, but the average VC only introduced us to 0.33 other investors. That’s a 5x difference!

Why do angels make 5x more introductions?

First, angels usually take a small piece of a Seed or Series A. If they like the company, they need to make introductions because they need co-investors. VCs usually don’t want or need co-investors–if they like a company, they want to buy as much as they can.

Second, some angels are followers, not leaders. They find a company they like but they don’t want to lead the investment. So they introduce you to a top-tier firm like Blue Shirt Capital and say to themselves,

“If Blue Shirt wants to invest, the company must be good. Plus, Blue Shirt will do all the work, and I’ll go along for the ride. I know Blue Shirt won’t cut me out since I introduced them to the company—firms that cut out the middleman stop getting intros.”

“Our series A didn’t happen quickly. We excited the people we met with, but we were timid about getting started having recently closed a $100k angel round. One firm had interest, so we thought “We better talk to someone else to make sure we’re getting a good deal.” That incremental approach went on for a few months. We were always in late stages with one investor but just beginning the dialogue with another. Deciding to raise money should be an atomic decision; don’t try to just dip your toe in.”

You can’t clear the market in series. You have to do it in parallel. You can’t create an auction by meeting investors one-at-a-time. The only way to get a market clearing price is to meet a lot of investors at once.

On eBay, everybody bids at the same time, over a short and arbitrary period of time. That drives the price up. They don’t bid one-at-a-time over a timespan of ‘whenever’.

As for how to create an auction, here’s the short version:

Jump on your desk, kick your laptop across the room and declare a start to your fund-raising; set up 10 investor meetings for the same week; you will probably end up meeting only 4-6 of them due to scheduling conflicts; tell them “We plan to sign a term sheet in 6 weeks, if we don’t have an offer by then, we’re going back to using sweat equity to build the company“; signal your valuation by saying “We want to raise $X from n investors with no more than Y% dilution, including the option pool,” (Y = 15%-25% per investor plus a 10%-20% option pool dilution). In a tight process with VCs, there are three meetings; one with the original partner you were introduced to; next, you meet the original partner with a few other partners; finally, you go to a partner’s meeting; there may also be an intermediate meeting where some of the partners come to your office to refactor your code and eat your food; if some investors are being slow while others are moving along, tell the slow ones, “By the way, we are on second meetings with three funds.” If things go well, you should receive 2-3 term sheets; reject the ones that explode the next day: “We told other investors that they have until the end of the week to send us term sheets, we can’t break our promise.” Negotiate the offers over the next 2-3 days and get your favorite investor to the terms you want. During closing, keep your other prospective investors warm in case the deal blows up; but don’t break any binding no-shop or non-disclosure agreements in the process.

Auctions and artificial deadlines create a positive feedback loop of social proof (“Other people want to invest, don’t you?”) and scarcity (“Hurry up or the deal is going to disappear”). That’s what closes deals. Auctions also force you to fail or succeed in a few weeks. Either way, you will soon get back to creating value for your customers.

Finally, don’t use the a-word (‘auction’) when you’re raising money. Investors don’t like it. Auctions are “taboo” when you’re selling part of your company to an investor, yet perfectly dandy when you’re selling your whole company to an acquirer. Don’t say, “We’re running an auction to get the best deal”, say “We’re looking for the right partner to help build our business.”

Tranches are dumb.

Adam writes:

“Traunching is bad for the company. If your investors exercise the traunche(s) then it means that the company is now worth more than they’re paying you, so you’re leaving value on the table. You might want to raise a smaller round and go to the market again when your valuation is higher.”

Tranches are generally stupid. They have zero upside and catastrophic downside.

At best, tranches give your current investors a right to invest at yesterday’s valuation if your company is doing well. If your company is doing poorly, your investors will figure out how to get out of their obligation to invest. The tranches will probably have material adverse change clauses that allow your investors to get out of their obligation. Almost all tranches are call options for the investors, not put options for the company.

If your investors back out of a second tranche, you will need to figure out how to manage the negative signal that your current investors don’t want to invest in your company, even at yesterday’s valuation. Remember the Golden Rule:

“He who has the gold rules.”

Get the gold while you can. If your prospective investor wants tranches, say:

“Currently, we’re focused on raising this round, not the next one. Let’s negotiate the next round at the next round.”

Two investors aren’t always better than one.

We disagree with one claim in Adam’s article:

“… you want to have more than one major investor. If one firm is out of line then the other firm will be there to say “This is unreasonable”. You’ll get more varied inputs. Having more than one major investor means you’ll take a little more dilution, but I think it’s worthwhile.”

Yes and no. There are good arguments for bringing on one or two investors. We don’t have a strong opinion either way.

If you have two investors, you can play them off each other during closing if one of them is being slow or demanding, you can split them on the board so one of them votes your way, you can split them when they vote their protective provisions, et cetera.

But, the additional dilution of two investors is usually significant, about 10%-15%. And you don’t need two investors to remove the unreasonable terms that Adam wants to avoid, you can just run an auction:

“We have an offer that doesn’t include [egregious term X]. I hope there is some flexibility on your side because I would really like to work with you but I have a fiduciary duty to our shareholders.”

It’s easier to remove unreasonable terms when investors are fighting to win a deal–they’re more likely to collude if they’re co-investing.

Graduating YC Founders: Don’t do deals on D-Day.

Me: Dude, we should offer to help the Y Combinator companies with their term sheets.

Naval: Don’t we already have a blog for that?

Me: Yes, I’m sure both of our readers are well educated by now.

Naval: It doesn’t matter anyway… the good YC companies will get snatched up on demo day–savvy investors will force quick decisions.

Me: What’s the rush? The YC founders should spend a week to get multiple offers. Good investors compete with their merits, not exploding offers.